Last week, trade protectionism re-emerged as a concern not only among the crowds gathered in Davos for the World Economic Forum, but also among financial market participants seeking to gauge the impact of a rising risk of protectionism. We at Morgan Stanley Research conclude that the near-term risk to our baseline forecast of stronger growth and higher inflation is very limited.

For starters, uncertainty around trade protectionism is clearly increasing, but it is still low relative to history. As the chart below shows, this is true both for the publicly available index by Professors Baker and Bloom, as well as our proprietary Real-Time Trade Policy Uncertainty indicator.

That said, my cross-asset colleagues are calling for higher volatility this year. But they are aware of the challenge of monetizing this view. The challenge stems from the so-called ‘carry’ (i.e., the difference between implied and realized volatility) being unusually high, especially for equities at the moment. This is causing volatility curves to become very steep.

As a result, Volatility Index (VIX) spot levels are near the bottom of the range, even though VIX futures price-in a full median reversion in the second half of the year. That said, the fundamental picture continues to argue for higher volatility on the back of a maturing global cycle and the higher uncertainty about central bank policy that comes with it.

Assessing the Impact in Asia

For Asia, our experts believe that the response from the region is likely to be measured and hence should not be fueling further trade friction. The impact on overall trade growth in Asia will likely remain manageable.

For China, we only see a mild impact of the U.S. tariff hikes on solar panels and washing machines, given that these product categories account for 0.1% of China’s exports. Should the U.S. impose additional tariffs on steel and aluminum, a hypothetical tariff of 100% would likely lower China’s exports by 0.3pp. We believe that only if the investigation into intellectual property issues leads to material increases in the tariffs the U.S. imposes on telecommunication and semi-conductor imports could this potentially translate into a more meaningful dent in China’s exports of around 0.8pp.

From an investment point of view, the rising risk of trade protectionism is one of several factors that could cause the present bull market in Asia emerging markets equities to wane later this year. A perceived move towards protectionist policies together with comments by senior U.S. officials was seen to reinforce the weak U.S. dollar trend.

Country Macro Vulnerabilities

Vis-à-vis the euro, the move in the EUR/USD exchange rate has started to make the European Central Bank a little uncomfortable, as last Thursday’s press conference demonstrated. A material weakness in the dollar over and above what we were assuming in the 2018 Global Macro Outlook would introduce upside risks to U.S. inflation in the second half of 2018 and in 2019.

If those upside risks materialized, the Fed might have to hike faster than we currently assume and push real short rates above their equilibrium level more materially. In such a setting, concerns about the U.S. economy overheating would likely revive.

Away from the dollar itself, currencies of close U.S. trading partners would likely look vulnerable too if trade tensions rose materially, including the Canadian dollar and the Mexican peso. For both pairs, ongoing NAFTA renegotiations could prove to be a catalyst in the coming months ahead of the expiry of the U.S. fast-track authority and the Mexican presidential election. Ahead of the mid-term elections in late 2018, our U.S. public policy expert, Michael Zezas, expects a tilt away from fiscal policy initiatives towards trade policy and regulatory changes where the U.S. administration has more discretion.

Growth, Inflation, and Multiples

Against this public policy backdrop, our U.S. equity strategists argue that signs of rising protectionism could start to shift market perceptions regarding U.S. inflation and long-term growth. While they remain bullish on U.S. equities, deterioration in the outlook for inflation and long-term growth could weigh on multiples later this year. This echoes our concern that the tone in the inflation debate in the U.S. could shift from welcoming rising inflation as reflation underpins risk assets, towards worrying about rising inflation as a sign of overheating which could eventually undermine risk assets.

A full-on globalization backlash could undermine hopes for shifting away from secular stagnation by derailing the nascent recovery in investment spending and productivity growth in the U.S. Global trade tends to boost productivity through fostering of competitive pressures, product specialization, scale economies, global value chains and technology transfer. Bringing global trade intensity back to the pre-crisis norm would add 0.2pp to productivity growth, the OECD estimates. A normalization of trade intensity would further underpin the bullish view we adopted on productivity last year.

At this stage, rising trade risks are not changing our bullish views. Nonetheless, we are eager to run another update of the Morgan Stanley Global Leading Trade Indicator (MSGTLI) this week to see where global trade is headed in early 2018.